Maxwell Technologies: The Bottom is In

Tom Konrad CFA

In the month since Maxwell
Technologies (NASD:MXWL)
surprised
analysts with strong second quarter (Q2 2012) earnings, the
stock has maintained a trading range between $7.50 and $8,
comfortably above the $6-$7 range in which it had been trading for
most of the summer. Despite the roughly 20% gain, I believe
the stock has plenty of upside left as it recovers from its
previous depressed levels.

Why the Low Price?

A year ago, Maxwell was a cleantech darling, with analysts
predicting rapid growth as the company’s ultracapacitors were used
as key components in rapidly growing markets such as hybrid
vehicles and wind turbines in China, North America, and Europe.
But the crisis in Europe and delays getting ultracapacitors
incorporated in new automotive designs caused management to push
revenue growth estimates during the first quarter (Q1 2012)
conference call.

What followed was a classic example of the dangers of growth
stock investing. First, investors and analysts used
rosy growth projections to justify high forward earnings
multiples. Then rapidly rising stock prices drew in momentum
investors seeking to capitalize on the continuation of rapid gains
in a virtuous cycle. The rapidly rising stock price served to
confirm investors’ and analyst expectations of future growth, and
targets were repeatedly revised upwards. Stock market gains
also lent the company an aura of invincibility, and potential
risks were increasingly ignored by analysts, investors, and
management who interpreted the rising share price to mean that
nothing could possibly go wrong.

No company is invulnerable, and something always goes wrong
eventually. In Maxwell’s case, it was the European crisis,
which slowed growth in once robust markets, and the much
slower-than-expected process of getting Maxwell’s ultracapacitors
incorporated in new automotive designs. In the Q1 2012
conference call, Maxwell CEO David Schramm acknowledged this
reality by cutting revenue guidance for 2012 from
25% growth to 15-20% growth, but maintained long term growth
projections.

Virtuous Cycle Turns Vicious

Schramm clearly intended to tap on the brakes a little,
but just as the positive feedback of investor psychology inflated
the stock price on the upside, negative feedback exaggerated the
negative effects on the downside.

First, the downward revision of one year’s guidance led
analysts and investors to ask the previously unthinkable: If 2012
growth will be lower than we expect, why not future years as well?
Although Schramm only cut short term guidance,
investors adjusted their long term models, and in turn cut the
multiples they were willing to pay.

As a rough rule of thumb, growth investors are willing to accept
a Price/Earnings ratio equal to their projections of long term
growth, and optimism can lead them to focus on next year’s
projected earnings, rather than current or trailing earnings.
So when long term growth was expected at over 30%, and 2013
earnings were expected to be over $0.50, it felt easy to justify
paying over $20 for the stock, which is what it was trading for in
February. $20 is about $0.60 (expected earnings) times
35 (projected growth).

When investors expected long term growth of only 20%, and 2013
earnings projections were revised downward to $0.50 (because of
lower short term growth projections), growth investors found it
difficult to justify a price over $10 (= $0.50 x 20).

Then the feedback effects kicked in. Analysts began to
consider risks they had previously discounted, lowering
acceptable price multiples. With the stock price plunging,
momentum investors sold as well, driving the price lower still.
Growth mutual funds also decided that Maxwell no longer
qualified as a growth stock, and
sold substantial holdings, driving the price down further,
until Maxwell bottomed at $5.88 on July 24, when it traded at less
than 12 times then-projected 2013 earnings.

The Cycle Runs its Course

In June and July, negative feedback had run its course, allowing
the stock to reach a new equilibrium. Value investors
like myself were attracted by the much more conservative price
multiples on offer, and company insiders were
signalling that they thought the stock was a good value with fairly
aggressive buying.

When Maxwell reported Q2 earnings at the start of
August, investors’ fears that the Q1 guidance revision
would be the first of a series of downward revisions were allayed.
Despite slightly lower-than expected quarterly revenues,
Maxwell maintained revenue guidance for the year, and
showed good progress controlling costs. Investors had become
so pessimistic that even the
slightly disappointing revenues combined with good cost
control amounted to a positive surprise.

Now, analysts have stopped cutting earnings estimates. In
the last month, eleven analysts have revised expected 2012
earnings upward, and four have made upward revisions to 2013
earnings, with no downward revisions for either year, according to
First Call. Strengthening forward earnings estimates should
begin to draw new investors into the stock, as should the
continued confidence of company insiders. Schramm and a
director (Mark Rossi) each bought an additional 10,000 shares
shortly after the Q2 earnings announcement, for a total of
78,000 shares acquired by insiders since the Q1 announcement and
large price declines in late April.

What’s Next

Although the viscous cycle of declining expectations,
selling, and increased risk aversion seems to have run its course,
it’s unlikely that recently burned investors will return to their
former optimism soon. Fortunately, such optimism is
unnecessary to produce decent returns.

Analysts are currently expecting long term growth of 25%, but the
current $8 stock price means that MXWL is trading at only 24 times
expected 2012 earnings (33 cents), and 17 times expected 2013
earnings. Such pricing leaves some room for mild earnings
disappointments, to which the current set of relatively sober
investors will likely respond in a much more measured way than the
growth and momentum investors who formerly dominated the stock.
Positive earnings surprises will probably also be greeted
with equanimity.

To give a range of estimates of investors’ potential gains over
the next three years, consider three scenarios
for disappointing, in-line, or better-than-expected earnings
growth:

If Maxwell disappoints and produces only 20% growth over the next
three years, in September 2015 we will be looking at a stock with
current (2015) expected annual earnings of $0.57. 20% growth
would likely justify a 20 earnings multiple, for a price
of $11.40. If Maxwell meets expectations for the
next three years, expected 2015 earnings will be $0.64 cents, and
the price multiple should be around 25, for a stock price of
around $16. In the optimistic scenario of
faster-than-expected three year growth, we would be looking at
2015 earnings of $0.72 cents, and the positive earnings surprises
would have likely drawn growth and momentum investors back in,
meaning that the stock would likely be trading at a 30+ multiple
of expected 2016 earnings of $0.94, or $28.

Scenario

2015 Expected
Earnings

Multiple

9/2015 Expected Price

Annual Return

Low growth

$0.57

20

$11.40

12.5%

Expected
Growth

$0.64

25

$16.00

26.0%

High
Growth

$0.94

30 (times 2016
expected earnings)

$28.00

51.8%

I personally consider the “High Growth” scenario unlikely, and
prefer to invest in the expectation of the “Low Growth” scenario.
Even that relatively conservative scenario is not a
floor for future stock returns, but the possibility of more
optimistic scenarios should be sufficient to compensate for the
downside risks.

When a relatively conservative scenario like the “low growth”
scenario above still produces 12.5% long term annual expected
returns, I consider the stock a buy.

Disclosure: Long MXWL

This article was first
published on the author's Forbes.com blog, Green Stocks
on September 6th. Prices and returns in the article
reflect the $8 stock price at the time.

DISCLAIMER: Past performance is
not a guarantee or a reliable indicator of future results.
This article contains the current opinions of the author and
such opinions are subject to change without notice. This
article has been distributed for informational purposes only.
Forecasts, estimates, and certain information contained herein
should not be considered as investment advice or a
recommendation of any particular security, strategy or
investment product. Information contained herein has been
obtained from sources believed to be reliable, but not
guaranteed.